Tax Problem Fundamentals-Phase II Considerations

In my recent blogs, we looked at an overview of how to approach a tax problem and identified the two distinct phases of such problems that should be evaluated. This discussion picks up at the end of Phase I and the beginning of Phase II where now the focus is on how/whether the tax obligation will be paid.

When we get to Phase II of a tax problem, we are dealing with the collection efforts of what is generally regarded as the most powerful creditor in the country. As a general rule, the IRS has 10 years to collect unpaid taxes and the laws are written to enable the IRS to have considerable advantages when doing so. Having said that, the IRS can be expected to follow the rules quite carefully, thus making the IRS one of the most predictable creditors to be dealt with.

In the Phase II arena there are generally three different outcomes that can be pursued: no payment, partial payment, or full payment. Aside from the obvious distinction between these options, other considerations come into play as well. While of course the “no payment” outcome may seem very appealing, a determination that the taxpayer is presently unable to make payments– in IRS parlance the account is marked “currently not collectible” — is not necessarily a lasting solution. A currently not collectible determination is based upon detailed financial disclosure which demonstrates the taxpayer has neither available assets nor income in excess of necessary living expenses available. Because the tax debt is not canceled under these circumstances, should the taxpayer’s financial situation change before the 10 year collection period expires, the IRS may resume collection activity. For this reason, the no payment option does not necessarily bring closure.

The full payment option typically involves negotiating the timing for payment, and significantly, ensuring that more aggressive collection activity such as the filing of tax liens and issuance of tax levies does not occur while payment is made. As a general rule, the sooner the payment is made the easier it is to keep the IRS collection activity on hold. A promise of full payment within 60 or 90 days is usually enough to prevent any such activity. The promise to pay over four or five years may result in the filing of a tax lien. Factors such as the total amount owed, a history of noncompliance, and the type of assets owned may also come into play.

The partial payment option — the offer in compromise program — is the option that is getting the most publicity these days. There is nothing new about this option as the IRS has been entertaining offers in compromise for some time. Most offers are submitted on the basis that full payment can never be made due to current and anticipated future financial circumstances. Detailed financial disclosure is required in connection with this process. There are many rules pertaining to the valuation of assets, the calculation of income, and the allowance of expenses that go into the determination of a taxpayer’s ability to pay. There is no formula for an offer in compromise. That is to say, there is no minimum percentage of the balance owed that must be offered. If you owe the IRS $50,000 and your ability to pay is determined to be $1000, then the IRS will accept $1000 in full satisfaction. On the other hand, if your ability to pay is determined to be $50,100, then no amount less than full payment will be considered.

Often times when evaluating these Phase II options the possibility of filing bankruptcy should be considered. Income tax obligations that are more than three years old may be discharged in a bankruptcy action. The age of an income tax obligation is determined by the assessment date for the debt. Usually this is the date on which the tax return is filed for the year in question but there are many exceptions and modifications to these rules. Certain types of tax obligations such as payroll tax related penalties and state sales tax obligations are generally not dischargeable in bankruptcy. If an individual has debts other than tax liabilities, the bankruptcy option may be the solution for a number of problems. A professional focused only on taxes may overlook the value of this option.

Hopefully this discussion has illustrated that Phase I and Phase II issues present very different considerations. Many times a tax problem will require working through issues in each of these phases. When that is the case, some interesting strategies may evolve. My next blog will look at some of those strategies.